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What you need to know about Forex money management

March 24, 2016 11:44 UTC

Forex money management

In order to become a really good Forex trader and make profit of your activities, you need to have trading education, sense of the market, and self-organization. The ability to manage your Forex trading capital is crucial if you get involved with trading and start expecting the long-term profit. It is true that your every trade should be carefully planned and your entry and exit points well substantiated. What's more, you should plan your profit well ahead. In the long run, you should understand what you are going to do with your money, and how and when you will invest it. This is where money management in Forex comes in.

Many inexperienced traders submerge into currency trading without knowing the basic principles of FX money management. This inevitably leads to losses, as the volatile market holds lots of risks for every player. If, however, the rules of self-organization and of rational use of trading capital are observed, there is not much to fear. This article focuses on the main principles of money management, key methodologies, and useful tips which every beginner in trading should take to attention before moving to the more advanced trading process.

Where traders should begin

Normally, each career starts with learning. Currency trading is not different from any other occupation in this regard. Firstly, you should read as much information as you can. Fortunately, there are lots of free resources that will help you to acquire knowledge about the basic trading concepts, types of market, and factors which influence its volatility. Then you can get information about the principles, methodologies, and strategies of trading. You can get a demo account with a broker of your choice and try them all on practice. Importantly, getting acquainted with the Forex money management strategies as soon as possible will give you a significant advance.

The next step in every education process is to practice the skills you've acquired through learning. Theory is good, but you won't become a trader until you don't trade for real. Be sure to start with a small amount of money—it should be your risk capital, not the money you would otherwise spend on food or rent—do not invest everything at once. Experienced traders also advise to avoid making investments in one place.

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As soon as you have joined the Forex market, be sure to remember about money management. When correctly applied, it will make you more immune to potential losses. Below are some essential strategies and tips for successful management of finances in FX. Let's see them.

Always have a plan

Your trading plan in Forex can both serve as a money management strategy on its own or contain your management strategies. If you stick to the plan, there is a smaller chance that you follow your emotions or make impulsive decisions. Instead, you have a predefined sequence of actions and their variations, which will help you to keep your profit and stop your losses from occurring. Having a plan makes you certainly more organized and disciplined, which are very important characteristics of a Forex trader.

Accept the risk part

The previous guideline is about self-organization, rather than specifically about finance management. Now, this rule concerns money directly. As a trader, you should be aware that all your activities are associated with risks, and any trade might bring you losses. While thinking about the possible gains, most traders forget that they could just as easily lose their capital. It is better to always think about risks first, assess them, and consider gains afterwards.

Trading is very different from gambling. Here, consistent small profits are better than one-time big rewards. The is no quick win in Forex. Instead, there are risks, experience, and reasoning. Question yourself. For example, what will happen if you lose the amount of money that you are about to invest? Even if there is a slightest chance of losing it, don't trade before you make sure this won't affect you much.

Stop-loss orders will save your money

Stop-loss orders will protect you from losing money when the market behaves unpredictably. By setting them, you specify the price at which you want to buy or sell your position. If you want to manage your money effectively, than you should use stop-loss orders for each trade you start. You never know when it might save your capital. There is a general recommendation to set the stop-loss order at 2% of your trading capital. This way, you will not lose much.

You can choose one of the four conditions for making a stop in a stop-loss order. These are: volatility stop, equity stop, margin stop, and chart stop. It is up to your preferences and experience how to set a stop-loss. You can pick the percentage or number of pips when placing a stop-loss. For example, if you are trading USD/EUR pairs, by selecting a 40-pip stop-loss with a $20,000 account balance, you will lose just 80 USD on a trade.

While the main goal of every trader is to maximize profits, another important aspect of it should be minimizing losses. A stop-loss order is perfect for that. Its main purpose is to avoid situations where you lose more than you find it acceptable. You simply specify the price limit, beyond which you will buy or sell automatically. Other than waiting for the price to go the other direction, use stop-losses; they will save you money and time, and will provide you with valuable experience you can use to build up your trader's confidence.

Be careful with leverage

While stop-loss orders help traders minimize losses, leverage is a perfect tool for maximizing profits. Leverage is sort of a loan that a broker offers traders, so that they have a chance to make bigger trades and greater profit. If you have 2,000 USD on your account balance, and the leverage is 200:1, then you can trade up to 400,000 USD. The higher the leverage, the more it increases your profits. Thus,a leverage ratio of 500:1 would increase the traded amount and the gains by 500 times (20 USD might turn into 10,000 USD).

On the other hand, the potential losses are greater with bigger leverage ratio too. This is why it is better to avoid trading with high leverage. While it might increase your profit a few hundreds of times, it can also increase your loss. Use it cautiously and always be ready for the consequences.

More tips on money management in Forex

So, money management is what causes hardship in many currency traders, both new and experienced. While the first batch of Forex money management tips were more basic, designed for those who are still learning, the following strategies and approaches might be helpful to more professional traders. In any case, to successfully apply these tips in practice, you should be disciplined and capable of self-organization. So, follow the guidelines below and plan your trading activities.

Use stop-loss orders and analyze the result

One of the best Forex money management techniques involves using stop-loss orders. They will allow you to avoid high losses and survive longer. You can choose and set up your stop levels, so that you do not lose any significant amount in case the market turns against you. Still, you should always pay attention to stop-losses that you use and the results they bring. Might be, you should adjust them to your financial resources or your trading strategy. If you keep losing on trades, then it might be the time that you review your strategy.

Risk assessment

We have already mentioned that being aware of the risks is always a good money management Forex strategy. It should be clear to you that, if your assumed losses exceed potential gains, then there is no use making a trade. Often, however, it is hard to estimate the risks: this is why you can use trading calculators which can help you make the correct estimation and decide whether it is worth making a trade.

Restoring the financial balance

If you lost any of your capital through trading, you will need to spend much more time to cover what you've lost. To balance out the loss of 20%, you will need to make a 25% profit, as different fees and additional costs apply when trading. You should get used to the thought that you won't even it out so easily. So, make sure that you have enough money for the real life (which you would use on food, rent, and other important things). This is why some stop trading altogether. However, don't panic and hold together — your task is to make profit in the long run.

Use protective stops

Another way to reduce your potential losses is to use protective stops. This Forex money management strategy is similar to stop-loss orders. Once you've opened a position, you can set a stop either at a price level that guarantees you a minimum loss, or at a price level at which you will be still making some profit, even in cases of unpredictable price moves.

Avoid stress

Perhaps the unrivalled Forex trading money management strategy would be to reduce the levels of stress. It can be hard indeed, as trading is associated with risks, and risks presume potential losses, and losses mean stress. This is why most traders feel much pressure which results from their activity. Practicing relaxation would be a very good solution, but the best piece of advice is to accept the possibility of losses completely and invest only amounts that do not matter much to you.

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Trade responsively

With trading, there might be a temptation to increase gains more and more, especially if you've had your successful trades lately. An attitude like this will not benefit you in any way: it is usually just mere irrational greed. It might get you into excessive trading and cause some major financial trouble. Never act emotionally and never open a position if you cannot explain why you think now is a good time.

We hope that all our Forex money management strategies were useful and will continue to be this way. There are different tools and techniques which allow you getting more profit or averting losses; you should use them all, but always with caution. However, the most helpful tip you can get from an experienced trader is that you need to plan your activities and analyze the results. Self-organization and learning will make you a profitable trader.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.